Bonds are the prototypical traditional investments, as opposed to stocks, which are more speculative in nature. When you invest in bonds, you pay the par value of the bond, plus any premium or minus any discount, plus any accrued interest, plus any commissions, and you receive fixed annual interest payments specified by the coupon rate, typically twice yearly until the bond "matures," when you are repaid the par value of the bond.

Barring defaults in interest or principal, bonds are a great way to save and grow your money steadily, especially during periods of high interest rates when you can get yields comparable to or exceeding that of stock returns. Here are the steps to get you started investing in bonds.

Note: All dollar amounts refer to US dollars, and the bond types referred to relate to the United States of America's bond market.

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Steps

1

Understand what a bond is. A bond is an interest-bearing certificate, issued by either government agencies (these are known as treasury bonds, agency bonds, municipal bonds, etc.) or private corporations (these are known as corporate bonds). Bonds pay a fixed amount of interest on specified dates, usually every six months, until maturity or redemption. Treasury bonds have no risk of default (because the government controls the money printing press and can print whatever money it needs to pay the interest or principal on its bonds), while corporate bonds carry the risk of default on interest, principal, or both.

Interest payment dates (IPDs) are the dates interest is paid on a bond, typically on the first or fifteenth of the month.

Maturity is the date the bond can be redeemed for its par value. A bond may be redeemed prior to maturity in accordance with the bond’s call provision. Typically, bonds can be called only at or above par, with a higher premium accompanying an earlier redemption.

The coupon rate is the percentage yield of the bond at par. For example, a bond with a par value of $1000 and a coupon rate of 12% pays $120 interest annually.

Current yield is the percentage yield of the bond at its market price. After issuance, a bond fluctuates in price on the open market according to supply and demand as well as general interest rate levels. For example, a bond with a par value of $1000, a coupon rate of 12%, and current market price of $800 has a current yield of 15% ($120/$800). The current yield is the most important yield figure in comparing the attractiveness of bonds of similar quality.

Understand your financial needs. While bonds should be a part of almost anyone's portfolio, how much you should invest in bonds will depend on your age, risk tolerance, and personal circumstances. If you are in or near retirement, you might need to allocate more of your investments in favor of bonds so you can retire comfortably on a steady income and preserve your capital. If you are the kind of person who can’t sleep when the stock market drops, or you're tempted to sell in a panic as stocks fall, buying Treasury or investment-grade bonds and holding them to maturity may help you reduce risk. If you are saving for an important purchase, such as a home, a car, or a college education, bonds can help you build the cash you need faster than a savings account or certificates of deposit. You should invest in stocks with only money that you will not need for 20 years, because over the short term, stocks fluctuate and can be down significantly when you need the money.

Before investing, consider buying a home first, if you are renting and if you already have the funds for a down payment. Owning a home will help protect you against inflation. During periods of high interest rates, rents tend to go up every year dramatically and may even force a renter to live in an undesirable place. If you do not have the money to buy a home, you can use bonds to help you build the cash you need for that purpose.

3

Learn more about bonds. Some of the best information resources for bonds include:

Learn about the different types of bonds. There are various bond types, and understanding their purpose will help you to decide which ones will benefit you most. The most common bond types include:

Debentures, or unsecured bonds, are the most common type of taxable bonds. All corporate bonds not pledged as assets or property are debentures.

Mortgage bonds have specific corporate property pledged as collateral for the issue. In case the bond issuer defaults on either interest or principal payment, the mortgaged property may be sold to pay the bond bearers. Due to the added security, these bonds typically have lower yield than debentures.

Ginnie Mae bonds and mortgaged-backed securities (MBS) are shares in federally backed home mortgages (USA). As homeowners repay their mortgages, the proceeds are divided up and paid to the bond holders until the mortgage is paid off.

Senior versus subordinate bonds: senior bonds have priority over subordinate bonds in the payment of interest and eventual redemption. This distinction is generally used only when a company runs into financial hardship which may force it into bankruptcy.

Convertible bonds are bonds that can be converted to a specified number of common shares of company stock. For example, a bond with a $1000 par value and a conversion price of $25 is convertible to 40 shares of the company's common stock. When the common stock trades above $25, the bond will trade in sync with the stock. When the common stock trades below $25, the bond is valued by its interest yield. Corporations typically issue convertible bonds to pay a lower coupon rate than nonconvertible bonds, especially when the common stock is not otherwise attractive, so the convertible bond will draw more investors to its stock.

Treasury bonds are bonds issued by the U.S. Treasury and backed by the full faith and credit of the federal government. Because of the government's ability to print money, Treasury bonds have no credit risk. Moreover, they are usually non-callable. Because Treasury bonds are the highest-quality bonds obtainable, all other bonds must offer a better yield than Treasury bonds with similar maturity in order to attract investors.

Tax-free bonds, or tax-exempt bonds, or municipal bonds, are issued by cities, counties, states, and other government agencies. These bonds are free of federal taxes. They are especially suited for investors in the highest tax brackets for holding in taxable accounts.

Zero-coupon bonds defer all interest payments until maturity. They are issued at an offering price significantly below par, for example, $150 to $250 when the redemption par value is $1000. Even though no interest is received, the holder of a zero-coupon bond must pay taxes on accrued interest every year. Thus, zero-coupon bonds are most suitable for retirement accounts where the bond is held to maturity.

Suppose a long-term bond is issued at par $1000 when the prevailing interest rate is 5%. To be attractive as an investment-grade bond, it would have a coupon rate equal to 5%, paying $50 yearly interest. Now suppose the interest rate rises 10%, to 5.5%. Investors can now buy new issues with a coupon rate of 5.5%. To have a comparable yield, the old bond with 5% coupon rate would have to drop about 10% in price (to sell at $909) to have a comparable current yield of 5.5% and be equally attractive ($50/0.055 = $909).

The lesson here is that bonds are great investments during periods of high interest rates, especially at the peak when they are about to fall, so that the investor benefits from both the higher income available and capital gains when the interest rate falls. Conversely, bonds make poor investments during periods of low interest rates, as the income is low and the bonds will fall in price as interest rates rise, giving the investor a capital loss if he decides to sell before maturity, or if the bond is called.

6

Look for reputable discount bond brokers. Most bond brokers are also stockbrokers. Consider what bond choices are available, what bond research is provided, and whether timely Quote and Sizes are available. Pay attention to both the commission and the spread. Commissions for bond purchases typically range from $1 to $4 per bond, with a typical commission between $8 and $30 per transaction. "Spread" is the difference between the ask price (the price at which you can buy) and the bid price (the price at which you can sell). For example, if the ask price for a bond is $60, while the bid price is $58, the spread is $2, which goes to the broker. Spread typically narrows with marketability of the bond. Scarce bonds tend to have wider spreads. Other places to buy bonds include:

Locate bond offerings. Brokerages provide lists of available bonds in offering sheets, and you can search for bonds meeting certain criteria. Bond guides, stock guides, the Wall Street Journal, and Standard & Poor’s website are all great places to identify bonds for potential investment.

8

Check the bond ratings provided by S&P and Moody’s. These ratings are a rough measurement of a bond’s safety in both interest and principal. S&P’s ratings are AAA, AA, A, BBB, BB, B, CCC, CC, C; the corresponding Moody’s ratings are Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. AAA is the highest rating by both services. D is sometimes used for a bond already in default and is the lowest rating possible. NR, or no rating, is used when the bond issuer did not request a rating, insufficient information is available to make a rating, or rating is not applicable to the specific type of bond involved. In general, bonds rated BB or below are junk bonds (which are deemed at risk of default). S&P modifies these ratings by assigning (+) or (-) to further rate a bond’s relative standing within each category. Moody’s adds numeric suffixes to designate these differences, such as Aa1, Aa2, Aa3.[1]

Do not rely entirely on these ratings. They are meant be used only as a rough guide to investing in bonds, and their ratings are typically slow to get updated, even after adverse corporate events have been reported.

9

Do your own bond research. Determine the following: the type of bond, its interest payment dates and maturity date, at least a three-year history of the issuer’s total interest charges versus earnings ratio or interest coverage (the higher this ratio, the more likely the issuer will be able to pay interest on its bonds, and the higher the quality of the bond), call provisions, total long-term debt and debt-to-equity ratio, a default-free history going back at least ten years, price trading ranges of the bond, current yield, yield to maturity, and any accrued interest on the bond.

10

Buy TIPS (Treasury inflation-protected bonds), the only investment guaranteed to beat inflation. TIPS are a special type of Treasury bond created in 1997 to provide investors protection from inflation. The face value of a TIP starts at $1000, and it is increased each year by the percentage rise in the CPI (Consumer Price Index), a weighted average of prices paid by urban consumers for a wide basket of consumer goods and services. TIPS are arguably the best investment in bonds, because they essentially eliminate the two biggest risks associated with bond investing: credit risk and inflation risk. The caveat with TIPS is that the CPI may or may not represent the prices you pay for goods and services, because prices can vary by local and regional circumstances. Another caveat is that even though you do not get the money added to the bond's principal until maturity of the bond, you nevertheless have to pay taxes at the ordinary income rate on the amount credited to the account every year. This does not apply to tax-sheltered accounts such as 401(k)s and IRAs, so that these are ideal places to hold TIPS until maturity.

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Buy discount bonds (bonds selling below par $1000). Bonds generally sell at a discount when interest rates have gone up since the bond was issued. Given a choice between an older bond selling at a discount and a new issue at par, both with the same current yield and quality, choose the older bond selling at a discount. The reason is that the discount serves as a call protection, because the company loses money by calling the bond and paying par value $1000 for it. Instead, if the company wishes to call the bond, it will simply buy the bond on the open market at a price below par. For this reason, never buy a bond at a premium (selling above par), because the company can choose to call the bond and you would realize an immediate capital loss equal to the premium you paid.

12

Buy convertible bonds when the yield is higher than 2% below the yield of nonconvertible bonds of equal quality. Convertible bonds offer the holder an option to convert the bond to a specific number of common stock shares of the same company at a price above the market price. For example, a company whose stock trades at $10/share may issue a bond with a 5% coupon rate, convertible for 60 shares of common stock. The conversion price of this bond would be $16.67 ($1000/60). When the common stock appreciates above the conversion price, the convertible bond will fluctuate in proportion to the stock. Because of the conversion feature, convertible bonds historically have a yield about 2% below a nonconvertible bond of equal quality. When the yield of nonconvertible bond minus the yield of convertible bond is less than 2%, it is a good time to buy convertible bonds. When the yield of nonconvertible bond minus the yield of convertible bond is higher than 2%, convertible bonds are overvalued, and nonconvertible bonds are a better value for the money.

13

Choose a low expense-ratio bond fund to invest in junk bonds (also known as “high-yield bonds”). Bond funds are investment products offered by brokerages and private corporations to make money for the fund managers, either in substantial acquisition fees (“loads”) or yearly management fees (represented by the expense ratio), or both. As a result of these fees, investors will generally obtain a higher yield by investing in individual bonds instead. The main benefit of bond funds, however, is instant diversification. A bond fund may own hundreds of different bonds, thereby minimizing the effect of a few poor investments within the overall portfolio. The benefit of diversification diminishes in the case of government bonds, which have no risk of default, and high-quality corporate bonds, which have low risk of default. The only place where bond funds are preferable to individual bonds is in the realm of junk bonds, where the default risk is high. To obtain true diversification with individual junk bonds, an investor would need at least 20 different bonds, involving substantial capital and commission fees. Therefore, to invest in junk bonds, it is best to choose a junk bond fund, such as SPDR Barclays Capital High Yield Bond (JNK), with the lowest expense ratio possible.

14

Buy tax-free bonds to place in a taxable account, especially if you are in a high tax bracket. Tax-free bonds will have a lower yield than taxable bonds. To determine whether you would benefit from buying tax-free bonds, multiply the taxable bond yield by (1 - your tax bracket), where your tax bracket is the percentage of tax you pay. If the result is greater than the tax-free bond yield, you will earn more after taxes by buying taxable bonds. If the result is less than the tax-free bond yield, you should buy tax-free bonds for your taxable accounts.

Here is an example: suppose the highest yield obtainable for investment-grade, tax-free bonds is 4%, while the highest yield obtainable for investment-grade, taxable bonds is 6%, and your tax bracket is 35%. Multiply 6% by (1 - 35%), resulting in 3.9%. Since the yield on tax-free bonds is greater, you should buy tax-free bonds. Note that the opposite conclusion is true in this example if your tax bracket is less than 33%.

15

Develop a bond buying strategy. Like stocks, bonds fluctuate in price, and the best time to buy bonds is when the prices are low. Bond prices are lowest when the interest rate peaks. That is the ideal time to buy because you benefit not only from better yields, but also from capital gains when interest rates start to decline. Interest rates tend to peak when short-term rates equal or exceed long-term rates, creating an inverted yield curve, a rare opportunity to buy bonds at great prices. During periods of high interest rates, investors prefer longer-maturity bonds to lock in the high yields, while corporations facing high interest costs prefer to take out loans on a short-term basis. The greater demand for long-term bonds coupled with reduced supply causes lower interest rates among longer maturities.

Determine how much of your assets to allocate for bonds. A rough rule of thumb is that your age should equal the percentage of your assets in bonds and fixed income, and the rest in stocks. For example, if you are 25, you should have 25% of your assets in bonds, and 75% in stocks. If you are 55, you should have 55% in bonds and 45% in stocks. Your bond allocation may vary depending on your financial situation and risk tolerance.

To mitigate interest rate risk, build a bond ladder consisting of short- and intermediate-term bonds maturing at one-year intervals. For example, if you have $50,000 to invest in bonds, invest $10,000 each in bonds maturing in one, two, three, four and five years respectively. When the shortest-term bond matures after one year, reinvest the proceeds in a new bond maturing in five years. Repeat this every year, so your bond portfolio always contains five bonds, maturing in one-year intervals. Bond laddering is a sound investment strategy because short-term bonds are less sensitive to interest rate fluctuations. Should interest rates rise, you have the opportunity to reinvest in a higher-yielding bond as your bonds mature.

16

Finished.

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Tips

Bonds are ideal for an investment horizon of five years or less. For example, if you are saving money for a down payment to buy a house in three years, invest in bonds that mature in three years, and stay away from stocks, which are too volatile short-term.

Use a limit order instead of a market order when buying bonds even if you are willing to buy at or above the ask price. The bid and ask prices may change before a market order reaches the exchange floor, so a limit order is always wise to prevent paying more than you expected when you placed the order.

If interest rates rise significantly after you have bought bonds, consider selling the bonds at a loss and replacing them with higher-yielding ones. The capital loss you realise will give you a tax benefit, and the higher-yielding bonds mean higher income in the long term. This should be done only within a taxable account in order to reap the tax benefit of a capital loss, and the tax benefit must offset any trading costs involved. All securities in a tax- sheltered account should be held until maturity.

If you have any debt, consider paying off all your debt before investing. Most people would agree that you shouldn't borrow at 3% to invest at 5%, as the increased risk in leveraging yourself is not worth the negligible payout. Investing while you still have debt is essentially the same thing, except that the interest on your debt is likely to be higher than whatever interest your investments might pay you, so that you're losing ground every month.

Compare the yields of bonds with the dividend yields of stocks. During periods of high, double-digit interest rates, as happened in the late 1970s and early 1980s, it is possible to buy risk-free, long-term Treasury bonds that offer double-digit yields exceeding returns that can be reasonably expected from the stock market. As a rule of thumb, when interest rates on long-term Treasury bonds exceed the S&P 500's dividend yield by more than six percentage points, sell your stocks and buy bonds.

Since Treasury bonds have no risk of default, they are inherently superior in quality to all corporate bonds, and therefore offer lower yields. Agency bonds and corporate bonds must offer higher yield to compensate for the increased risk of default. For example, if a ten-year Treasury bond offers a 4% yield, while a ten-year corporate bond offers a 5% yield, there is an implicit market assumption that the corporation has a 1% risk of default each year. If you are risk-averse, or the yields on Treasury bonds and investment-grade corporate bonds are comparable, or if you have no time or inclination to research corporate bonds, go with Treasury bonds to protect your capital.

Warnings

Do not buy tax-free bonds for tax-sheltered retirement accounts, such as an IRA or 401(k). Buy only taxable bonds for these accounts, and look for the highest yield. Tax-free bonds, such as municipal bonds, are useless for retirement accounts, because the accounts will pay taxes when the money is withdrawn regardless of the source.

Avoid zero-coupon bonds. Bonds are supposed to pay interest, and zeroes don't, so technically zeroes should not be considered bonds. Interest on zero-coupon bonds is deferred until maturity, but you still have to pay taxes on the accrued interest every year even though you received nothing. Zeroes are more volatile than conventional bonds because they lock in a given interest rate, while interest payments on conventional bonds can be reinvested at prevailing interest rates. It is not uncommon for zeroes to plunge 20% in value in just a few weeks. The only rational place for zeroes is in tax-advantaged retirement accounts where you don't have to pay taxes on interest you do not receive. Buy zeroes only if you can hold them until maturity, buying them when the prevailing interest rate is high, preferably in the double digits.

All bonds, including Treasury bonds, carry inflation risk, i.e. the principal and fixed interest of the bond will tend to be eroded by inflation and will be worth less over time. The inflation risk is greater for longer-term bonds.

If you have discretionary money you will not need for at least 20 years, you should consider investing in stocks instead of (or in addition to) bonds. Stocks have historically provided a much better return than bonds.

Limit bond purchases during periods of low interest rates. Interest rates have averaged about 5% historically. If you buy bonds when prevailing interest rates are low, you'll get a lower yield if interest rates increase, and you'll incur a capital loss if you sell the bond prior to maturity or if you paid a premium for the bond.

Avoid bond funds investing in government bonds or high-grade corporate bonds. The main advantage of bond funds is diversification, which is much less important in the case of government bonds or high-grade corporate bonds with no or little risk of default. Bond funds also have no defined maturity date, and they fluctuate in price inversely with the prevailing interest rates. The buyer of an individual bond is assured of getting back the par value of the bond at maturity no matter what the interest rate is at that time. The buyer of a bond fund, however, will receive at redemption only the market price of the fund, which may have declined substantially. The investor is better served buying individual government bonds or high-grade corporate bonds to get a higher yield without paying yearly fund-management fees. The only bond funds worthy of consideration are junk-bond funds, where diversification offsets credit risk. All the same, you should invest only money you can afford to lose.